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In a sorry market, you can only be safe with bonds

Caution is the order of the day, says this Canadian advisory. The only way to have a secure source of income is to buy government bonds.

The other day, we were reminded of one of those signs you used to see in roadside general stores: “We don’t take credit for anything — so don’t give us any. Cash only.” Maybe they should have hung one of those signs in the traders’ room at Bear Stearns.

With the credit markets apparently getting worse before they get better, it’s not easy to decide where to turn for income. At the beginning of this week, we relayed the advice of a leading U.S. advisory that income investors were liable to get more from utilities than from bonds.

Today, we have a Canadian point of view. And it’s quite different.

Writing in Investor’s Digest of Canada, Mr. Grant Campbell says that the morass of the credit markets is no place to be taking any chances. The answer is bonds. And only government bonds.

Mr. Campbell, an independent online analyst, has three exchange-traded funds (ETFs) he likes as a way of securing good yields. And he has a very dim view of the general state of the markets.

Scared out of the financial sector

“The best and the brightest on Bay Street and Wall Street have been working overtime to try and control an out-of-control market,” says Mr. Campbell, “so far with very little success.”

The precipitous plummet of Bear Stearns and its subsequent rescue by the U.S. Federal Reserve Board and JP Morgan Chase is a well-known saga by now. But it’s not an isolated incident.

“If this doesn’t scare everyone out of the financial sector, I don’t know what will,” says the analyst. “This points out just how little is known about the value of these firms. It could be x amount a share or zero, depending on the amount of faith investors have that the loan portfolio will be repaid. So who really knows?”

The Bear Stearns bailout sent a dark message to the investment community. “The fact that the Federal Reserve was required to fund the buyout, taking steps that have not been required since the 1930s should send a signal to investors that the credit market is in far worse shape than previously forecast,” states Mr. Campbell.

In the meantime, Bay Street has its own troubles.

Struggling to a deal

“The Canadian credit market is struggling to finalize a deal in the asset-backed corporate-paper sector where $35 billion has been frozen since last August, when the secondary market stopped functioning,” says the analyst, who was writing before a proposal came down.

Now the deal has been put on the table, to the general dismay of large corporate investors. In a rare turn of events, individual investors wound up with a better deal than big investors. Lawsuits will surely ensue.

Whatever happens with this accord, there is still the spectre of huge losses in the financial sector, says Mr. Campbell, “and nobody can say with certainty what value there will be in the end, adding considerable risk to the Canadian market.”

To top it all off, the economic slowdown in the U.S., which was caused by the credit crisis in the first place, has the potential to be the worst in over thirty years, in the analyst’s opinion. The figures are pointing to a repeat of the recession of 1972-74, the worst in five decades.

The bulk of an income portfolio

“If the current slowdown becomes that severe,” says Mr. Campbell, “corporate profits will be exceedingly hard to come by.” The potential for more Bear Stearns-type surprises will increase dramatically, on both sides of the border.

“Investors looking for income should be very cautious regarding the issuer of any bonds,” he adds. “The bulk of an income portfolio should be invested in securities issued by the government of Canada or the provinces.”

Beware corporate bonds. “The uncertainty in the corporate sector is high enough that investors should avoid this sector; the increase in yield may not be reflecting the full degree of risk attached to corporate bonds.”

With these substantial caveats in mind, Mr. Campbell recommends three ETFs from Barclays Global Investors to his Investor’s Digest of Canada readers. All track Scotia Capital bond indexes, which are the benchmark for bonds in Canada.

iShares CDN Scotia Capital Short Term Bond Index Fund (TSX-XSB) tracks the Scotia Capital Short Term Bond Index and does so at a low fee of 0.25 per cent of net asset value. It holds 94 bonds with an average term to maturity of 3.12 years and an average weighted yield of 3.64 and duration (the average maturity of the bonds’ cash flows) of 2.81 years. It holds some corporate bonds, but the majority of the portfolio is in government-issued bonds.

iShares CDN Scotia Capital All Government Bond Index Fund (TSX-XGB) tracks the Scotia Capital Government Bond Index. It holds 57 government bonds with an average weighted term of 10.7 years, duration of 6.7 years and an average yield of 3.7 per cent. The units have a very low Management Expense Ratio (MER) of 0.35 per cent and pay quarterly distributions in March, June, September and December.

iShares CDN Scotia Capital All Government Bond Index Fund (TSX-XLB) tracks the Scotia Capital Long Bond Index. It holds 88 bonds with an average weighted term of 22.25 years and an average yield of 4.62 per cent. It also pays quarterly distributions and has a low MER of 0.35 per cent.

You would have to drive a long way today to find a store that doesn’t take a credit card or a swipe card. But the folks who took cash only lived by a simple creed: you only got what you could pay for. It looks like some folks on the Street tried to get what they didn’t really pay for, and the bill is coming due.